Problem 17-8 Financial Distress Good Time Company is a regional chain department
ID: 2776991 • Letter: P
Question
Problem 17-8 Financial Distress
Good Time Company is a regional chain department store. It will remain in business for one more year. The probability of a boom year is 80 percent and the probability of a recession is 20 percent. It is projected that the company will generate a total cash flow of $189 million in a boom year and $80 million in a recession. The company's required debt payment at the end of the year is $114 million. The market value of the company’s outstanding debt is $87 million. The company pays no taxes.
What payoff do bondholders expect to receive in the event of a recession? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)
What is the promised return on the company's debt? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
What is the expected return on the company's debt? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
Good Time Company is a regional chain department store. It will remain in business for one more year. The probability of a boom year is 80 percent and the probability of a recession is 20 percent. It is projected that the company will generate a total cash flow of $189 million in a boom year and $80 million in a recession. The company's required debt payment at the end of the year is $114 million. The market value of the company’s outstanding debt is $87 million. The company pays no taxes.
Explanation / Answer
a) Cash Flow expected in case of recession = $80 million
Required Debt Payment at the end of year = $114 million
Since bondholders have the first right to the cash flows, that is, they are paid off before the shareholders in case the company liquidates, the payoff that the bondholders can expect to receive in case of a recession
= $80 million = $80,000,000 (as the expected cash flow is lesser than the required debt payment)
b)Market Value of Debt = $87 million
Rerquired debt payment at the end of the year = $114 million
Hence , promised return on company's debt = [(114 - 87)/87] * 100 = (27/87) * 100 = 0.3103 * 100 = 31.03%
c)Market Value of Debt = $87 million
Expected Cash Flow at the end of year 1
= Probability of Boom * Cash Flow in case of Boom + Probability of Recession * Cash Flow in case of Recession
= 80% * 189 + 20% * 80 = 151.2 + 16 = $167.2 million
Since expected cash flow is greater than the required debt payment and bondholders are given preference in case the company liquidates, the bondholdes are expected to receive the entire reuqired payment of $114 million.
Hence, Expected return = [(114 - 87)/87] * 100 = (27/87) * 100 = 0.3103 * 100 = 31.03%